It all adds up

A dollar saved is a dollar earned. With markets continuing to provide a bumpy ride and returns remaining low, investors seem determined to apply this old adage and are searching for ways to save.

Index funds seem to be one way to fit the bill. Whether it is managed index funds or listed ETFs, low cost passive investments are winning a healthy share of investment inflows. 

The total funds under management (FUM) held in index funds is also growing – unlike that of many actively managed funds. 

The continuing popularity of index funds as a cheap way for institutional investors such as super funds to access market returns has seen passive funds avoid much of the outflow problems being experienced by many active managers.

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According to data from research house Plan For Life, wholesale FUM in managed index funds totalled almost $29 billion in the March quarter 2012 – a solid rise from the market low of $18.8 billion in the March quarter 2009. This contrasts with the total FUM for the wholesale market, which peaked in March 2011 before declining in March 2012 (see Table 1).

Michael Elsworth, Lonsec’s research manager – investments, agrees there has been growing interest and inflows into indexed products. “The big four – BlackRock, Vanguard, State Street and Russell – have enjoyed good growth,” he says.

Despite the steady FUM growth by unlisted indexed funds, most attention has been centred on the rapid expansion of their listed cousins in the ETF sector, which saw 78 ETFs listed on the Australian Securities Exchange in early July. 

“There has been an increasing number of ETFs continuing to come onto the market,” Elsworth notes.

“Their FUM has increased – but not exponentially – and now is approximately $5.2 billion. However, compared to the managed index fund space, it is still tiny.”

Although growth has been strong, the enthusiasm for ETFs is still a far cry from the situation in the US, where ETFs represent 25-30 per cent of the market.

Emphasis on cost

Although Australian institutional investors embraced index funds years ago, for retail investors, cost seems to be the key motivation for the current interest.

According to Robin Bowerman, head of corporate affairs and market development at Vanguard Investments Australia, concern about investment expenses has been a big push factor behind the growth in indexing. “We have seen a focus on cost. There has been an increase in usage of indexing as a low cost way of doing a portfolio.”

The Investment Trends SMSF Report released in June also noted portfolio costs were a key driver of dissatisfaction among SMSF investors. This preoccupation is reflected in the findings of the recent BetaShares/Investment Trends December 2011 ETF Report, which found cost was a key rationale driving investment in ETFs. The research found investors had (on average) 3.5 reasons for using ETFs, with diversification (73 per cent) and low cost (57 per cent) the most commonly cited ones.

“We see that investors – particularly in the SMSF sector – have become much more attuned to the fees they are paying,” Bowerman says.

“Higher volatility and lower returns have focused investors on the things they can control within their investment portfolio.”

The fee difference can be fairly compelling. With most actively managed Australian equities funds charging around 0.9 per cent to 1 per cent, on 1 August, the new wholesale management fee for Vanguard’s Australian Shares Index Fund dropped from 0.34 per cent to 0.18 per cent, while the management cost for its Australian Shares Index ETF is 0.15 per cent.

In announcing the reduced fee scale, Vanguard’s head of product management and development, Robyn Laidlaw, said this was “an environment where costs matter more than ever” and some of Vanguard’s funds were now priced “about one-fifth of the average Australian managed fund fee” for comparable asset classes.

Elsworth agrees cost explains much of the interest in indexing at the moment, but believes there are subtle differences within the market.

“There are two different types of investors interested in indexing products. ETFs suit direct equity investors and SMSFs, while index managed funds tend to be more for the adviser market,” he explains.

Bowerman agrees SMSFs in particular have embraced the ETF approach to indexing. “We have seen a stronger take-up of ETFs by SMSFs than advisers. This represents a change to the listed equities space.”

Regulatory boost to indexing 

From the adviser side, cost has become a significant focus due to the regulatory changes reshaping the advice market. 

“Financial planners have been caught in a perfect storm due to the changing investment environment and regulatory change. The market environment has been very volatile and has provided low returns, which leads to an increasing focus on investment costs,” Bowerman says.

“Low investment returns have led to disaffection with active management by planners and clients, and this has made indexing look very practical, and with less fees.”

He believes local investors are increasingly aware of the impact of management expenses. “Investors are very savvy about the difficulty of predicting manager performance, but they know they can control costs.”

Introduction of the Future of Financial Advice (FOFA) and MySuper reforms is also forcing advisers to focus more closely on expenses and to seek investment solutions offering lower pricing.

“The FOFA reforms have led to concern about the client’s best interests test and the fees charged. Concern about maintaining dealer group fees has also led to an interest in indexing to lower fees and safeguard margins,” Bowerman explains.

Although concern about margins and the shift from commission to fee-for-advice is making indexing attractive, some in the industry believe there are also other motives at work.

Russel Pillemer, CEO of active equities manager Pengana Capital believes discussion about management costs provides a useful distraction. 

“Some financial planners are using management expense ratio (MER) discussions as a key selling feature. It is difficult to continue discussing poor returns, but it can be a good point to discuss ways to reduce client expenses,” he notes.

“They are using it as a selling tool to deliver good news, not poor return news.”

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“Vanguard has lowered fees quite substantially. However, they argue it is due to increased efficiency and due to their larger volume in FUM.”

According to Bowerman, managed index funds have not felt any pressure to reduce fees in the current environment.

“From an adviser’s perspective, some people asked questions [about costs] a few years ago, but most of them access managed funds through platforms, so they get wholesale pricing and it is less of an issue,” he says.

“Our fees declined due to Vanguard building scale in Australia over 15 years.”

Despite the growth of ETFs, Bowerman believes traditional managed index funds have little to fear.

“ETFs and managed funds have been different doors to enter indexing. ETFs are part of the indexing growth story, but they have had greater publicity in recent years,” he says.

“Managed funds makes sense for advisers – especially in a platform environment – for taking a core plus satellites approach to a portfolio.”

Bowerman argues both forms of index fund answer the question about investment costs. “ETFs are a very low cost product offer, but they have a different business service proposition to managed funds, so it is a different interaction.”

He believes the emphasis on cost is unlikely to disappear and will continue driving changes in the investment market. 

“We think MERs will continue to come under pressure across the whole industry for the next five to 10 years. This is a good thing for the industry and clients, as we will see better results for investors. Pressure will continue on all parts of the value chain to reduce fees to clients,” Bowerman says.

Cheaper at a price?

Although indexing may offer cheaper fees, active managers argue it comes at a price – which advisers and clients need to recognise.

Pillemer believes there is a high potential cost to investors in the drive to lower MERs. He argues a retreat to index funds and low-cost options is robbing portfolios of investment strategies that effectively combat volatility.

“Anything you save in an index fund will be dwarfed by the losses you will incur if there is a big market downturn. Saving 20-60 basis points will be very insignificant in a big investment market downturn,” he argues.

“Not all financial planners and clients are focussing on MER or cost. If the fund is performing well, the cost saving is a rounding error,” Pillemer says.

He argues some active managers are performing despite the volatility, and this performance will make many investors question their attachment to a low cost index approach. By way of example, Pillemer cites Pengana’s Australian Equity Core Fund which returned 8.3 per cent over the 12 months to 30 June 2012, while the All Ords was down 7.0 per cent over the same period. 

“You could have saved 50-70 basis points by indexing and still be down 7 per cent,” he notes.

According to Pillemer, if the active manager is performing, investors are less concerned about cost. He argues really good active managers use performance fees and are not losing business to indexers. 

“A lot of ‘closet indexers’ are charging active management fees and that is the space where mandates are being lost. That is where some of the money that has gone into index funds has come from,” he says.

“For those active managers that have shown they can deliver good numbers over the last few years, cost is not as big an issue.”

Higher MERs is the price investors must pay for active protection in a volatile market. “We speak to investors and they say our product is expensive compared to index funds, but that is the price of actively looking after the portfolio,” Pillemer says.

“Active management is for protection and you can’t get good protection at a very cheap price.”